Exploring economic and financial instability within global markets and economies.

Thursday, September 8, 2011

Equity Analysts' Forgotten Word: Sell

Each day, various Wall Street equity analysts update stock recommendations and issue new opinions on previously uncovered securities. Depending on the mood of the market and prestige of the analyst, these recommendations can move a stock by several percent in a day. Numerous investors and money managers pay significant sums for these opinions, which subsequently aid in determining whether to buy, sell or hold specific stocks. Considering the amount of money spent on employing these analysts and the profit derived from their reports, one is persuaded to assume significant predictive value lies within Wall Street's research. Is this a fair assumption, or is Wall Street selling snake oil?Well, according to recent data "published by Sam Stovall, the chief investment strategist of Standard & Poor’s Equity Research," the answer is almost certainly the latter. An article on MarketWatch yesterday by Robert Powell titled, Things are bad, but analysts can’t say ‘sell’, highlights Stovall's analysis. The numbers speak for themselves:

“Consider, at a place and time such as this, with the economy teetering on the verge of another recession, none of the 1,485 stocks that make up the S&P 1,500 has a consensus “Sell” rating. And just five, or 0.3%, are ranked as being a “Weak Hold.””

"There were (don’t laugh) just 167 (0.08%) “Sell” recommendations and 697 (4.2%) “Weak Hold” recommendations out of a total of the 19,868 Wall Street research reports reviewed in Stovall’s analysis."

Although Stovall's research screams of bias, he attempts to conceive of valid reasons the numbers are so skewed. One explanation offered is that “if stocks for the long run are on an upward trajectory, then everything is a hold.” At first glance this statement appears plausible enough to gloss over, but upon further examination it is extremely flawed. When people discuss stocks having risen throughout history, they are generally referring to an index such as the S&P 500 or Dow. An important factor often overlooked in this comment is that those indexes are weighted based on market capitalization and price, respectively. This means that stocks which perform better over long periods exert far greater influence on the direction of the entire index than stocks that perform poorly. It should also be remembered that the worst stocks are frequently swapped out of these indexes for stronger ones, creating a survivor bias. Consider these stocks from 1980:

Those companies were all included in the Dow at the start of the 1980’s, yet many of the names are likely foreign to investors today because the stocks (and companies) no longer exist. The point that Stovall’s reasoning misses is one of basic capitalism. In the long run, most companies fail as new technologies and forms of production eliminate economic profits. The only way to avoid this outcome is through monopolies, either natural or government created. So unless analysts believe capitalism no longer exists in the US, it makes little sense to assume all stocks are at least a hold.In our everyday lives, if a friend always gave the same advice, most of us would likely stop seeking advice from that friend. Regardless of the economic or market outlook, Wall Street recommendations consistently and uniformly provide the same guidance. Despite this knowledge, markets and investors continue to hand over money for Wall Street’s opinions. Stovall’s analysis is a helpful step towards unveiling the truth about Wall Street recommendations. Hopefully further research will expose the currently subjective process and ensure that stock recommendations are more objective in the future.

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